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Healthy FCF drives debt reduction

Varroc Engineering’s (VEL) Q2FY21 operating performance was ahead of consensus estimates as EBITDA margin came in at 9.1% (up 53bps YoY). VLS’ sales grew ~21% YoY to EUR228mn while margins were flat YoY to 7.6% (tad disappointing). FCF generation (~Rs4bn) in 2Q has been strong and is supporting VEL debt reduction target of Rs26bn by 4Q. FY22 is likely to be the point of inflection for earnings for global lighting business (VLS) as utilisations rise in greenfield plants coupled further aided by the fixed cost reductions initiated in FY21. India business is expected to benefit from revival in domestic 2-W demand recovery coupled with increased BS-VI content. Stock remains attractive at ~21% FY22 FCF yield. We maintain our BUY rating on the stock.

* Key highlights of the quarter: Topline at Rs29.4bn grew 8.4% YoY despite India business revenue decline of 7.2% to ~Rs9.3bn, while margins grew 329bps YoY to 13.5%. EBITDA margin stood at 9.1%, up 53bps YoY. China JV performance improved with 16.8% EBITDA margin as revenues grew 12% to Rs1.2bn. VLS sales grew ~10% YoY at EUR228mn, while India business also grew 10% YoY as 2-W OEMs geared up for festive inventory buildup. Free cashflow for the quarter stood at ~Rs4bn, which resulted in net debt reduction of Rs3.5bn to Rs30.6bn to reach the target of Rs26bn in FY21. VEL reported PAT loss of Rs401mn as tax rates were higher as loss absorption w.r.t greenfield plants could not be accounted for, the same could normalise as operations deliver consistent profitability in H2/FY22.

* VLS ramp-up as VEL focuses on cost optimisation: a) VEL reported new business wins of EUR74mn in VLS and Rs5bn in India business, with a pipeline of EUR120mn of likely orders in the near term; b) capex for FY21 has been significantly slashed to EUR45mn for VLS and Rs1.3bn for India business; and c) inventory buildup by OEMs has led to strong volume growth in VLS and India business in Sep/Oct’20. VEL is not yet impacted by the second wave of lockdowns in the Europe although end-customer demand may possibly be impacted.

* Maintain BUY: VLS remains an attractive play on the move towards higher LED penetration among global OEMs and cost reduction from the ramp-up of greenfield facilities. We expect VEL’s revenue growth at ~16% CAGR over FY21-FY23E. We lower our FY22E EPS estimates by ~4% on of account higher interest, depreciation costs. Due to the mixing of global and domestic automotive exposures, we value the business on SoTP basis. We rollover to Sep’22E and value VLS and its China JV at 4x EV/EBITDA and 7x P/E Sep’22E, respectively, and India business at unchanged multiple of 8x EV/EBITDA Sep’22E to arrive at a SoTP-based target price of Rs491 (earlier: Rs412). Maintain BUY.

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